A couple of years ago upon the birth of our second child, my wife convinced me that it was finally time to sell my two-door sports car and buy a minivan. After a couple of sleepless nights thinking about it on the couch, I agreed and placed an ad in the newspaper.

I received an offer over the phone from someone out of province who was going to fly in, potentially buy the car and drive it home. He liked the car and after the test drive he asked if I would like to go to the bank with him to conclude the sale. The teller prepared the draft, and I handed him the keys and the bill of sale to conclude the transaction.

After immediately depositing the draft (we had accounts at the same bank), the teller said that I must have done my homework because a common fraud is when an out-of-towner buys a car with a fake bank draft and drives off with the car before the seller makes it to the bank.

It was quite fortunate I decided to go to the bank with the purchaser, because I had no idea about this type of scam – not surprising given my infrequency of selling cars. Many Canadians have not been so fortunate.

During our many years in the investment business, we’ve read and heard about a number of scams that investors, with the right questions and precautions, could have avoided. With that in mind, we’ve put together a Top 10 list of the basic rules for assessing new investment opportunities.

1) Ask if the investment is registered with a provincial securities commission or Investment Industry Regulatory Organization of Canada (IIROC). IIROC and many regulators have a check-first search engine on their websites where you can find out if the firm and the individual selling an investment are registered. If they’re registered, check for past warnings or disciplinary actions. If they’re not, stay away.

2) Beware of “Friends and Family” or “Hot Deal” taglines. If the investment is that good, you’ll never see it because the seller would likely take it to an institutional investment manager who has much deeper pockets than you.

3) Be cautious when approached with a “great investment opportunity” from someone in your church, professional association or community group. Con man is short for confidence man and the quickest way to gain someone’s confidence is to move in the same social circles and purport to share their values and ethics.

4) Remember that if it sounds too good to be true, it most likely is. Most scams reel in investors with a pitch of “guaranteed” or “low risk returns” of 30% or more. Risk and investment return go hand in hand: The higher the return potential, the greater the risk.

5) Ask about the disclosure requirements and access to regular financial statements audited by a well-known independent third-party accounting firm.

6) Never write a cheque payable to the person offering the investment. Just ask those who wrote cheques to Earl Jones or Bernie Madoff. In particular, look for a third-party custodian who will hold your investment independent of the person managing the investment.

7) Always ask for specifics about the timing and process of getting your money out.

9) Always ask how the investment seller is getting paid and remember there is no such thing as a free lunch.

10) Finally, and most importantly, don’t be afraid to show any investment to your accountant, lawyer and investment counsellor. Fraudsters will do everything they can to prevent you from doing this.

If, despite all these precautions, you still get victimized, make sure to immediately report it to the RCMP and your local provincial securities regulator. The vast majority of investment fraud and scams go unreported and continue to operate for long periods of time, drawing in even more unsuspecting people.

Martin Pelletier, CFA, is a portfolio manager at TriVest Wealth Counsel Ltd., a Calgary-based private client and institutional investment management firm specializing in discretionary risk-managed balanced portfolios as well as specialty offerings including an oil and gas hedge fund.

The market has had one heck of a rally from the doldrums of last fall, with the S&P 500 reaching its highest level since June 2008. We still see the potential for stock markets to move even higher on the back of a pickup in institutional buying. However, we consider this rally to be one of those “hold-your nose” sorts, because markets are reaching new weekly highs despite several near-term risks.

In particular, there are a number of factors that many pundits seem to be ignoring that could derail the current momentum, including: rapidly climbing oil prices, the upcoming Greek elections and corporate earnings that appear to be peaking.

The greatest risk is the rapidly increasing price of oil against a backdrop of poor global demand fundamentals. In particular, we are quite worried about the rapid increase in the price of Brent crude, which, when valued in euros, is now at its highest point ever, even surpassing its 2008 pre-financial crisis high. This comes at a time when the euro-zone economy is contracting.

What’s even more troubling is that rising oil prices will have immediate implications for China, which is one of the leaders of the economic global recovery. Many seem to forget that Europe is China’s largest customer, representing 40% of its total exported goods.

There are already signs that a weakening Europe is starting to impact China. For example, Japan posted a record trade deficit in January in which its exports to China fell off a cliff, collapsing a whopping 20.1% over last year’s levels. China is Japan’s main export market and the curtailment in exports to China last month contributed to 40% of Japan’s record setting 1.48-trillion yen trade deficit in the month.

Another issue is the yet-tobe resolved European debt crisis. Bond investors are still wondering whether Greece will undergo a structured or disorderly default. The EU has been somewhat successful in getting the current Greek government to agree to more punitive austerity measures, but the concessions could unravel following the Greek elections this April.

We are also keeping a very close eye on corporate earnings, which appear to have rolled over in the fourth quarter. There had been eight consecutive quarters of double digit earnings growth up until the recent quarter, after which the blended growth rate fell to 5.5% according to Bianco Research. Even worse, the estimated earnings growth rate has now fallen to zero today from 8.0% in September. In normal markets, investors drive stocks higher on the expectation of growth in revenue and earnings. This is no longer the case. While investors are currently benefiting from the resurgence in stock markets, we believe we’ve identified three good reasons for not getting too comfortable.

Times like these are excellent opportunities to implement some kind of a risk management plan. This can include using option strategies to protect the downside or adding tax-efficient income to a portfolio. For those who have yet to do their annual review, now would also be a great time to re-balance and review all holdings for overall potential downside risk.

– Martin Pelletier, CFA, is a portfolio manager at TriVest Wealth Counsel Ltd., a Calgary-based private client and institutional investment management firm specializing in discretionary risk-managed balanced portfolios as well as specialty offerings including an oil and gas hedge fund.

There are some very strange disconnects or what we term “head scratchers” in the current market as investors have been very selective in what they have purchased and sold.

We’ve found it extremely useful in identifying such discrepancies as they tend to be temporary in nature and thereby create unique opportunities for those contrarian investors. A current example of this is that for the most part of this year WTI oil prices were trading at a significant discount to Brent oil prices until more recently when this spread narrowed considerably on the announcement of the Seaway pipeline reversal.

According to our research, there are two disconnects that currently exist in the Canadian oil & gas sector: 1) There is a large valuation gap among Canadian oil & gas stocks as some companies continue to trade at all-time highs while others are trading near 2008 financial crisis levels; 2) Oil prices continue to ignore fundamentals significantly outperforming oil focused Canadian producers.

Firstly, one would think with the current fear in the equity markets that all publicly traded companies would be impacted to some extent. This is not the case in the Canadian oil & gas sector.

In particular, we’ve noticed a herding, especially among many of the Canadian institutional energy fund managers, into a select group of Canadian mid-capitalization E&Ps. We think this could change rather quickly especially should the global macro uncertainty continue into the first quarter of next year.

In our view, the catalyst would be capitulation by the investors in these funds as they finally begin to redeem units. Thereby, logic would dictate that the managers of these funds would in turn lock-in profits of those select companies trading at a substantial “air-pocket” valuation to their peers. Large block selling of such companies would also have an impact on retail investors the same way the large block buying did thereby compounding matters.

We’ve identified five companies that fit this description: Birchcliff Energy (BIR:TSX), Celtic Exploration (CLT:TSX), Paramount Resources (POU:TSX), Tourmaline Oil (TOU:TSX) and Trilogy Energy Corp. (TET:TSX). In our opinion, all of these are fundamentally sound companies having strong management teams with a very respectable track record, and a large resource base with near-term growth potential. However, we think the market is paying up for this in spades.

Investors in this group of companies have in our view completely shrugged off the global macro uncertainty as according to our calculations, as of Thursday’s close they have bid them up an amazing 71% year-to-date (35% when excluding Trilogy). This is a massive out performance to their peers, as the Horizons GMP Junior Oil and Gas Index is down over -24% year-to-date. Even the lower-risk large-cap E&Ps, the Capped Energy Index, has sold down nearly -17% this year.

What is even more confusing is that this group is on average 75% levered to natural gas, compared to their peers who just so happen to be on average only 54% weighted to natural gas. Why is this important? Well, AECO gas prices are down approximately -25% this year to a near record low of approximately $3.15/mcf. NYMEX gas prices have also fared worse selling off over -32% this year.

In regards to valuations, we estimate that this group is currently trading at 12.9x next year’s estimated cash flow, which is a 55% premium to its peers who are trading at only 8.3x. On a 2012E EV/BOED basis the group is trading at an average $116,000/boed which is a 33% premium to its peers of approximately $87,000/boed. It is also worth noting that both of these multiples are factoring in a continuation of these companies’ respectable growth profiles into next year.

Therefore, for the net longs out there, we see better risk-adjusted returns in owning the less expensive, more oil levered peer group used in our comparison as we expect the aforementioned valuation gap to narrow.

The second disconnect is the discrepancy in the performance of Canadian oil producers and oil prices. For example, Western Canada select crude oil prices are up over 25% this year while we calculate oil focused senior E&Ps and oil sands producers that are down nearly -19% on average.

We also expect this gap to narrow as either oil prices will sell off or these companies will rally.

Specifically, we believe that spot oil prices are factoring in a partial disruption in Iranian oil supplies and also completely disregard the state of the global economic recovery and the troubles coming out of Europe.

For some perspective, do you believe the three leading EU importers of Iranian oil who just so happen to be Italy, Spain and Greece are in a financial position to say they are o.k. with an Iranian oil embargo and even higher oil prices?

In the interim, speculators keep piling on their bullish bets. According to Bloomberg News, speculators’ have purchased 29% more call contracts with a $150/bbl strike price since November 8th which when added up currently represent about 38 million barrels of oil, or 43% of daily global demand.

In conclusion, although many pundits complain that is a difficult market to trade in given the excess volatility, on the flip side there are currently some inefficiencies created as a result and therefore opportunities for the contrarian in the crowd.

As we all know from time spent in London, it’s always prudent to “Mind the Gap.”

Disclosure: TriVest’s TWC Risk-Managed Canadian Energy Fund may hold a long and/or short position in any of the companies mentioned in this article.

This has no doubt been a very challenging market to get one’s head around for both regular investors and professional money managers alike.

Part of the problem is the huge day to day volatility in the equity markets which it not unusual to see +/- 1% to 4% daily moves. According to Bloomberg, the S&P 500 has moved on average 1.7% per day over the past four months which is more than double the average daily sings before September 2008, when Lehman Brothers collapsed.

Bespoke Investment Group provides a good illustration of this in their “All or Nothing Day” measure, which is when more than 400 of the 500 companies in the S&P 500 move up or down on any given day.

According to their analysis, of the 84 trading days from the beginning of August to November 28th, 43 of them have been all or nothing days. This is more than the total number of all or nothing days experienced over a 13 year period from the beginning of 1990 to the end of 2002.

This also means that there is a very high correlation between stocks in their respective indices. According to Forbes, the average trailing two-year correlation between S&P 500 stocks reached to 60% this past fall. This is higher than during the levels reached during the burst of the Internet bubble and the 1987 stock market crash. Forbes goes as far to call this an emerging correlation bubble.

This correlation makes it an especially difficult environment for those professional money managers who use fundamental research to make their investment decisions.

It is also impacting those prudent managers looking to hedge as higher volatility makes insurance premiums very expensive, and pair trading challenging. Therefore, not surprisingly, market volatility and high stock correlation is taking its toll on performance as less than a quarter of the funds tracked by Morningstar Inc. have beaten their benchmark indexes this year. This is the lowest level it’s been in the past decade, according to Bloomberg Businessweek.

So what is driving this volatility and correlation? As we identified in our write-up last week, “Is it time to go ‘all-in’ on stocks?” it certainly isn’t the longer-term “mom and pop” investors in U.S. equity mutual funds.

For example, October was the greatest monthly outflow from U.S. stock funds since July and yet the S&P 500 still managed to gain nearly 10.8% in the month. There was also $1.5 billion in net outflows in Canadian equity funds in October, representing an 84% drop from year ago levels, and yet the S&P TSX gained 5.6% in the month.

Logic would dictate that flow into and out of these funds, which in total represent roughly 20% of the ownership of the companies in the S&P 500, would have a strong influence on the U.S. equity market. However, when looking back to 2007 we’ve identified periods where the S&P 500 has completely disconnected to U.S. equity funds flow.

The first occurrence was the large sell off of the S&P 500 in 2009 and its subsequent recovery. The second was the large rally since June 2010, which just so happened to be near the commencement of QE2. The S&P 500 gained 21% over this period despite a whopping $259 billion of outflow from U.S. equity funds.

This leads us to exchange traded funds (ETF), which have experienced exponential growth in the past decade. For example, we’ve read that in the year 2000 there were only three major ETF providers in the U.S. and approximately 95 ETFs. This has subsequently grown to over 35 providers and over 1,500 ETFs.

ETF providers have also catered to speculators by creating more and more speculative ETFs such as double and triple levered products. This has allowed speculators to have a greater influence on near-term market volatility and performance as they bring emotion to the market reacting to headline reports.

Compounding matters is that many in the media have responded accordingly by trying to grab headline attention with bipolar and sensational reporting.

We came across this very interesting study entitled “Corporate News, Asset Prices, and the Media Event”. The paper provides evidence that U.S. investors don’t react to a corporate news event until it is reported on CNBC, often 24 hours following the event. The paper also found that there was a significant stock price response in the minutes following a feature of the opinions of security analysts.

Part of the problem is that contrary to mutual funds, which managers pick the stocks they buy and sell when faced with new unit purchases and redemptions, ETFs have to buy or sell an entire basket of stocks. Therefore when an ETF speculator reacts to a news event or media headline and either buys or sells units of the ETF, the ETF manager will subsequently rebalance by buying or selling the whole basket of underlying securities. This in turn greatly increases the correlation among the stocks purchased or sold.

In addition, trading in U.S. equity funds is not nearly as prolific as ETFs which are readily bought and sold each day on an exchange. Marginal buying and selling by speculators therefore have a huge impact on the daily movement of the equity markets driving both volatility and correlations higher. We think this explains a large portion of the explosive growth in the number of “all or nothing days” since 2005.

Going back to our October 2011 comparison, while U.S. investors sold $11.3 billion in equity mutual funds, investors plowed $12.2 billion into U.S. equity ETFs. This in our view this backstops the 10.8% move in the S&P 500 during the month.

We wonder if the growth in ETFs and their use by speculators can also be blamed for a number of other head scratching events. This could include the recent lock-step performance of European stocks relative the U.S. stocks, and the massive outperformance of oil prices compared to Canadian oil focused stocks.

Overall, we still believe in the merits of ETFs as a low-cost investment vehicle and their pressure on mutual fund managers to justify their higher fees with outperformance. It also provides long-term investors and professional money managers with many different investment options including the ability to hedge their portfolio.

However, unfortunately it has also given more influence to speculators who choose to treat the equity market like a casino allowing them to make daily bets based on headline reports. In the interim, this influence continues to expand as investors in U.S. equity funds react to the current market volatility by waving the white flag with a corresponding exodus into bond mutual funds.

That said, the markets will one day return to fundamentals as they always do and this is where day-to-day speculators will eventually learn a hard lesson that the house always wins.

We think 82-year old Mr. John Bogle, founder of the Vanguard group and whom many consider the father of ETfs, sums it up quite well in his August 2011 interview with Institutional Investor:

“Each year we trade about $40 trillion in stocks — with each other. Money keeps going back and forth, and the only winner is Wall Street. It’s just speculation in stocks, no different from going to Las Vegas, where the winners are the croupiers, the middlemen.

The original ads for Spider ETFs said, “Now you can trade the S&P 500 index all day long in real time”. What kind of lunatic would want to do that? A worthy purpose, but a terrible outcome for most ETF holders. I’ve been in this business for 60 years. In the long run it’s a mathematical truism: Investors win; speculators lose.”

There has been a lot of use in the financial press lately of the terms “risk-on” and “risk-off” in reference to the positioning by investors in the equity markets.

The market is classified as being “risk-on” whenever investors are layering in more equity buying than selling and thus driving the equity market higher. The “risk-off” occurs in markets such as this week when investors rush to sell equities and buy bonds or treasuries, which are safer investment vehicles.

Therefore one would think based on recent investor action that the equity market appears to be in a “risk-off” mode. However, we find it rather intriguing that equity markets have been moving contrary to what equity investors are actually doing, at least in the near-term anyway.

For example, October was the greatest monthly outflow from U.S. stock funds since July and yet the S&P 500 still managed to gain nearly 10.8% in the month.

According to Morningstar, investors redeemed a whopping $18.2 billion from U.S. stock funds in October, the greatest monthly outflow for the asset class since the $22.7 billion redeemed in July. There was also $1.5 billion in net outflows in Canadian equity funds in October, representing an 84% drop from year ago levels, and yet the S&P TSX gained 5.6% in the month.

That said, as of Thursday’s close the S&P TSX has is still down -19.5% from its highs earlier this year and is down -14.6% year-to-date. The energy and financial service sectors in particular have been hit hard selling off -31.4% and -21.8% from their earlier year highs and are down -22.0% and -14.6% year-to-date, respectively.

The contrarians out there view risk-off markets and sell offs such as what has occurred this year as being an excellent opportunity to take advantage of depressed valuations. While we tend to be contrarians ourselves, we think the current equity markets may not be fully risked quite yet. Despite the aforementioned sell-off, the S&P TSX is approximately 30% priced in for a European credit crisis, and 50% priced in for a recession, according to Fraser Mackenzie.

In markets like these, we think it’s wise to at least consider the unexpected including lower probability or tail risk events and not get too aggressive despite the odds being in one’s favor. Essentially, now is not the time to be enticed by the current market selloff and go “all-in” as should either of these events transpire there would be material downside.

Moto Mabuchi is very fortunate to have been dealt two Aces (known as pocket Aces) and then draws two Aces by the dealer to give him quad Aces. This is the third highest poker hand in ranking but based on the dealer draws the only hand that can beat him is a Royal Flush. However, the odds of this happening are estimated at roughly 2.7 billion to 1. So, Mr. Mabuchi makes a very logical decision and goes “all-in”, meaning that he bets all of his chips against his opponent, Justin Phillips.

Mr. Phillips surprisingly calls the all-in bet whereby he agrees to bet his chips against all of Mr. Mabuchi’s. Both of them now have to reveal their cards to see who wins, and Mr. Phillips shows his Royal Flush to win.

So, even in a situation where winning was nearly a foregone conclusion, the player lost everything. Although this is an extreme example, we think it highlights the prudence of taking a steady approach with a target of staying in the game.

We would still look to take advantage of market sell offs such as what has transpired over the past few weeks; however, that doesn’t mean betting the farm. This is where asset, market, sector and security diversification is paramount to achieve capital preservation and appreciation. Lastly, one should also be prepared for unexpected low probability events such as a full-blown European credit crisis or global recession. This can be done through various option and hedging strategies.

In these ridiculously volatile markets, it pays to have a risk-management plan in place as well as a good poker face.

]]>http://business.financialpost.com/uncategorized/is-it-time-to-go-all-in-on-stocks/feed0stdpokerBeing a philanthropist is a lot easier than you thinkhttp://business.financialpost.com/uncategorized/being-a-philanthropist-is-a-lot-easier-than-you-think
http://business.financialpost.com/uncategorized/being-a-philanthropist-is-a-lot-easier-than-you-think#respondFri, 28 Oct 2011 15:49:50 +0000http://business.financialpost.com/?p=105856

Over the past two decades there has been a large accumulation of wealth in Canada especially among those in the baby-boomer generation that have grown successful businesses and/or professional practices. We find that many of our clients now are not simply looking to retire on the fruits of their labour, but rather would like to contribute their time, talent, and treasure directly back to the community where they were able to benefit financially from.

Operating charities and public community foundations continue to be the dominant choice for many of these individuals. While these are excellent vehicles for those just looking to give financially, they offer limited flexibility for those wanting to play more of an active role in their philanthropic giving.

An option that is often missed or over looked is the creation of a private individual/family foundation. The primary benefit to setting up such a foundation is that it allows the individual or family to play more of an active role in their charitable giving.

For example, they would be able bring their years of experience into the new venture while not relinquishing control other than the transfer of assets from their own balance sheet onto their newly created foundation. In addition, parents can also involve their siblings in the foundation if they so choose thereby exposing them to the benefits of various philanthropic causes.

There are many other benefits of private foundations (a good reference is the September 2009 Estates, Trusts & Pensions Journal):

1) They allow for more flexibility in giving and do not have to consider the views of a broader donor base and board members in a public foundation.

2) They allow for more privacy compared to a public foundation as the individual’s or family’s personal finances are often made available to the staff or external board of directors of a public foundation.

3) When making a significant gift to a charity or public foundation the gift is essentially given away. In a private foundation, the individual or family retains significant control over both the use and investment of the funds by sitting on the board of directors, or trustees.

4) A private foundation also allows for an opportunity to grow the asset base over time allowing for the achievement of longer-term philanthropic goals.

5) There is more direct control over costs including administration and investments.

6) Setup costs have come down significantly in recent years thereby making the private foundation a viable option.

A current turn-key and time-effective means of setting up a private foundation is through the use of a shelf-foundation. This can be done at reasonable and competitive set-up and ongoing administrative costs with a minimum funding of approximately $2 million. This allows the philanthropist to focus on the important and fun part of running their own foundation while outsourcing all of the burdensome administration, compliance, and portfolio management responsibilities.

Lastly, there are some opportune times from a tax-planning perspective in setting up such a foundation. For example, some of our client’s foundations were set-up prior to the sale of their public and/or private company.

As we approach year-end and/or look to our plans for 2012, we think it’s well worth knowing the options currently available to maximise one’s giving and create that lasting legacy.

According to the Oct. 6 Bloomberg article entitled “Worst Oil Industry Slump Since Lehman May Herald Takeovers” energy companies in the UK and North America have seen the value of their reserves fall by 23% this year compared to Brent crude oil prices that have gained 8%. Essentially, equity investors have reacted much differently than institutional commodity traders by hitting the panic button and thereby pushing some energy company valuations to near 2008/2009 lows.

This in turn creates an excellent opportunity for those with large cash positions such as Asian buyers. According to Sanford Bernstein and as cited in the aforementioned article, Asian buyers may spend as much as $150-billion in energy acquisitions by 2016. We would expect Canada to be a major recipient given its reserve assets represents approximately 50% of the investable oil and gas reserve assets in the world, according to Deloitte Canada. In addition, Canada is often viewed globally as a secure source of unconventional crude oil and natural gas with the eventual build-out of export capacity.

Over the past two years Chinese firms have spent roughly $10-billion in Canadian energy investments. Just last weekend Sinopec announced that it was acquiring Daylight Energy Ltd. in a cash deal worth approximately $2.9-billion. Clearly Sinopec is taking a much more opportunistic longer-term view than equity investors given the 120% premium being offered to Daylight’s previous closing price.

In our view, Asian buyers may be looking at the current attractiveness of company valuations as an opportunity to consolidate rather than undertake joint venture agreements which can prove rather challenging to implement. This was evident by the collapse of the $5.4-billion joint venture between PetroChina and Encana earlier this year.

This is why we believe that some mid-capitalisation Canadian producers are likely an ideal target for Asian buyers. An outright acquisition not only brings an experienced management group but in many cases a large unexplored resource base given many of these companies have been constrained with the overall pace of development because of their large dividend payouts. In addition, they also offer a more manageable bite-sized entry point into Canada.

So far there have been three acquisitions in the Canadian mid-cap E&P sector by foreign buyers with PrimeWest Energy Trust being purchased by the Abu Dhabi National Energy Company (TAQA) in January 2008, Harvest Energy Trust being purchased by State-run Korea National Oil Corp. in October 2009, and Sinpoc’s recently announced acquisition of Daylight.

Despite this emerging trend, equity investors remain rather persistent in their negative outlook on certain mid-cap companies selling them off to large discounts to their 2P net asset value (under forward curve pricing). For example, Advantage Oil & Gas and Petrobakken Energy both trade at 65% of their net asset value, Zargon Oil & Gas at 75%, and NAL Energy Corp. and NuVista Energy both at 85%. Interestingly, Daylight was in this group trading just under 70% of its net asset value before being purchased for over 1.5 times.

As a side note, we are amazed at the investor selectivity in the sector as despite the significant near-term broader market risks on the horizon some companies are trading near their all-time highs such as Trilogy Energy at near three times its net asset value, Vermillion Energy at near 2 times, and Crescent Point Energy at 1.5 times.

Lastly, we think it is not unreasonable to think that many of those undervalued mid-cap companies may have taken notice and seen the Daylight. Stretched balance sheets, the lack of reasonably priced capital available in the equity and debt markets and most importantly unrealistic market valuations may provide just enough motivation for any management team in this group to wave the white flag. This is certainly not good news for those investors who have taken a rather short-term view and have been panic selling their positions in these companies over the past few months. Unfortunately these investors can at times end up getting burned by the Daylight.

Disclosure: TriVest’s TWC Risk-Managed Canadian Energy Fund and client managed accounts currently hold a position in Daylight Energy, and may hold a long and/or short position in any of the companies mentioned in this article.

An often overlooked risk-management strategy is regular portfolio rebalancing. Portfolio rebalancing essentially removes emotion from investment decision making by taking advantage of large market swings.

While this is a relatively easy concept to understand it can often prove to be quite the challenge to implement for the average investor. For example, questions arise as to the frequency, the amount, and the depth of rebalancing.

One of the benefits of working with an experienced investment manager is to assist in removing the emotion from the decision. In our view, periods of excessive market volatility, not unlike what is currently transpiring, create an excellent time to add or remove positions in a portfolio.

This can be done at many different levels depending on the mandate of the manager and their overall level of expertise. In our case, we see five rebalancing opportunities currently presenting themselves in this market environment.

Beginning from the top-down, we would expect those more conservative investors with a balanced mandate to currently have an overweight cash and bond position given the pullback in the equity markets. Specifically, the S&P TSX is down approximately -12.8% year-to-date compared to the Universe Bond Index that is up approximately 3.3%.

We think this may be as good an opportunity as any to look at reducing some of this excessive bond position and rebalance in a staged process back to a more balanced mandate.

For example, a portfolio originally comprised 60% equities and 40% bonds at the beginning of the year would now be roughly 55% equities and 45% bonds under the aforementioned scenario. Therefore, the investor would have 5% of their bond portfolio to purchase an incremental equity position.

The second area for rebalancing would be within global equity markets. While the S&P 500 is down only -7.0%, the resource heavy S&P TSX is down -12.8%, the EAFE markets are down nearly -14.5%, and the emerging markets are down a whopping -21.9%. Therefore, for those who have been underweight emerging markets or EAFE, perhaps it’s worth layering in an increased position.

We, for example, have used the option market to add a position in these foreign markets but at a 10% discount from current levels as we see some further near-term downside risks. That said, we structured the trade such that if we end up owning the position, we will do so at a 20% discount from already depressed levels (after including the benefit of the receiving the option premium).

The third area for rebalancing would be within the various sub-sectors in the equity markets. Looking at the Canadian equity market, there has been quite a bit of divergence in the performance of the various subsectors.

The Capped Telecommunications index is up 7.5% this year while Utilities are flat. This compares to the Capped Materials Index that is off nearly -15.9% while the Capped Energy index has been crushed down over -23.3%. Again, we think that for those with an underweight position in energy, this may be an excellent time to rebalance into the sector.

Fourthly, we see opportunities to rebalance among individual stock positions. As we mentioned in last week’s article “Navigating volatile markets”, we’ve seen a recent trend among advisors recommending defensive positioning. We think that now is certainly not the time to be rotating into expensive “defensive names” by selling those fundamentally sound companies trading at such levels that they are discounting another financial crisis.

However, it is very important to do one’s diligence and identify which well-run, financially sound companies that have been oversold and represent excellent value on a risk-adjusted basis.

Lastly, there is an opportunity for Tax Loss selling. Poorer quality names that have dropped significantly can be harvested for their tax loss and while being replaced with higher quality blue chip growth names. The tax loss can be banked while the replacement securities will track the market upward when it eventually recovers.

The equity markets have been amazingly resilient this year considering there have been a number of material events that have occurred and a lot of unresolved issues on the immediate horizon.

This includes the Japanese tsunami, the ongoing troubles at the Fukushima Dai-ichi nuclear plant (which for some reason no longer makes the headlines), the European sovereign debt crisis, rapidly increasing inflation in emerging markets, the recent stall-out in the global economic recovery, and the fast approaching U.S. debt ceiling. In addition to all of this, the U.S. Federal Reserve’s back-stop to the equity markets (QE2) expires today.

For example, the markets appear to be putting Greece on the back burner with the government’s passing of incremental austerity measures on Wednesday and the vote today on its implementation. This was rather important as additional funding from the EU was conditional on these measures being adopted in full.

This reprieve may be short-lived though as the Greeks and other troubled countries such as Ireland, Spain and Portugal will soon be facing higher debt financing costs as the European Central bank likely continues raising interest rates next week.

Therefore, while credit spreads have recently narrowed on Greek bonds, they have widened on Ireland and Portuguese bonds.

The second immediate concern is that the U.S. is projected to reach its $14.3 trillion debt ceiling by August 2, 2011. According to a coalition of former budget officials and as cited in Bloomberg, should Congress not approve an increase in this ceiling, the U.S. government will be unable to fund over 50% of its current obligations in addition to having to temporarily lay off over 800,000 federal workers.

In particular, we like the quote by Alan Blinder, a former Federal Reserve vice chairman, in Tuesday’s Bloomberg interview. “I find too many market people, Wall Street people, unconcerned, which tells me that if this actually happens, it’s going to be like a cold slap in the face. I don’t know what probability to put on this. It’s not huge. It’s certainly way under 50 percent. But it’s not zero.”

That said, according to a recent CNN Money survey, Wall Street analysts remain exceptionally bullish with the lowest target on the S&P 500 being a gain of 6% this year. We think this sentiment is best described by Reuter’s article title “Bulls ready to charge into a wall of worry.”

Why so bullish? Many of these analysts have been focusing on their strong corporate earnings outlook essentially shrugging off the recent broader global events as non-impacting.

Specifically, they have recently increased their second quarter corporate earnings estimates on average by 9% to currently reflect a 16% quarter-over-quarter increase, according to the Wall Street Journal. Let’s hope corporate America doesn’t disappoint.

This disregard for some of the near-term risks is also evident in the options market. The Chicago Board Options Exchange’s Volatility Index (VIX), moves up and down depending on the price that investors are paying for options on the Standard & Poor’s 500 Stock Index.

When investors become worried about the market, the demand for put options on the S&P rise and become more expensive. The VIX then moves higher. Conversely, when investors sell those put options on the S&P, the options become less expensive and the VIX moves lower. The options activity reflects traders’ expectations of market conditions three or six months into the future.

The VIX is currently trading at approximately 16.1 which is 20% below its long-term average of 20. To add some perspective, this is similar to levels seen in early 2007 and well below the highs of 80 during the financial crisis in 2008/2009. This is also 60% below the level reached during the mild correction in the spring of 2010.

This in our view means there is still an opportunity for investors to hedge against some of the aforementioned risks on the horizon. In particular, we’re not alone in noticing the relatively inexpensive put premiums in the market.

“It’s almost like the market’s in denial and it’s very strange and causing a little bit of apprehension. There’s a lot of confusion and people aren’t sure how they want to position themselves.” – Dan Deming, a VIX options trader at Stutland Equities LLC on the CBOE floor, as cited in a Bloomberg article.

While many retail brokers expound on the use of “stop-losses” as a risk-management tool, we think put options are the only tool that effectively guarantees the downside in one’s portfolio.

The problem with stop-losses is that in a volatile market a company’s share price may fall rapidly or “gap-down” in such a short period of time that the investor’s stop-loss would not be executed. In addition, at times a stop-loss may be executed and the stock rallies back shortly thereafter.

In the case of a put being purchased, the investor knows exactly how long they are protected for and at what specific price. For example, if an investor had owned the S&P TSX or in this case the proxy being the iShares S&P/TSX 60 Index Fund (XIU), they would be up nearly 14.5% in the past one year. Let’s say they wanted to minimize the downside to a 5% loss. They could currently buy a September 17, 2011 put option with an $18.00 strike for approximately $0.25.

Essentially, the investor is giving up only 1.3% of their upside to carry them through the aforementioned near-term market uncertainties. Should the market fall by more than 5% during this period, the investor will lock-in a 7.9% return on their portfolio. This downside may not be unreasonable as since early March the XIU has fallen as much as 10.5%.

In conclusion, we think it’s currently not too late for investors to have a relatively inexpensive risk-management plan introduced into their portfolio. This can allow for a longer-term bullish stance on the market while providing a ladder at a reasonable price to get over that “wall of worry” should any of the current risks materialize.

Some interesting trends in the Canadian oil patch have emerged as of late with the near conclusion of the first quarter reporting season. We’ve also been proactive with our meeting schedule having met with a number of oil & gas companies who have since reported.

Overall, it appears that the upcoming second quarter will prove to be quite the challenge for many companies with declining production and higher operating costs. In particular, there has been an above-normal amount of precipitation in parts of southern Alberta and Saskatchewan, which has caused a prolonged spring break-up.

This will result in a delay in many drilling and completion programs in those regions and as a result impact the timing of new production additions.

There has also been abnormally dry conditions in parts of northeast Alberta, which has caused forest fires and consequently disrupted some existing production volumes. We recommend the Alberta Environment precipitation map, which highlights the amount of precipitation by region.

Lastly, there has been an above normal amount of plant turnarounds and pipeline outages which has also impacted output.

Overall, we estimate that junior and intermediate sized oil & gas companies will be the most impacted. Many will be challenged to grow their production, let alone keep it flat in the second quarter. This may also lead to downward revisions to 2011 growth targets, which has already started to occur.

Adding fuel to the fire are rising land sale costs in addition to increasing completion and drilling costs in regions where there is currently a lot of activity such as Central Alberta.

So costs are going up, production down, and consequently lower cash flow and earnings assuming commodity prices remain flat heading into summer. Not the best picture to be painting in an already volatile market environment.

That said, we think there are two potential ways to play this.

Firstly, we believe the safer trade at the moment is in owning the intermediate producers rather than the juniors. As we highlighted in our May 27th article, “Understanding growth vs risk in energy stocks,” most junior producers spend in excess of their cash flow, which could be impacted from the delay in new production adds as well as higher operating costs.

Therefore, those who are not well capitalized may find it rather difficult to tap the secondary market for capital, which in our view currently does not have a lot of appetite for risk.

Compare this to intermediate producers, who on average are only 50% to 60% drawn on their credit facilities with an average dividend yield of 5%. While production targets may be scaled back, at least the investor is getting paid an attractive yield backstopped by a strong financial position.

The second way to play this may be through a pick-up in M&A activity as some juniors look to wave the white flag and lock-in an attractive return for their investors or un-lock additional value not currently being realized in the market. The aforementioned intermediate producers would be the logical buyers as they look to back-fill in their growth targets.

This makes some sense as the intermediates still maintain a lower cost of capital advantage to the juniors. For example, we estimate that the intermediates are currently trading at an approximate 20% premium on price to cash-flow, 6% premium on enterprise value to 2011 estimated production, and a 25% premium on a price to net asset value when compared to the junior producers.

In conclusion, we would exercise caution on the M&A trade as determining which companies are a potential take-out candidate can be a very challenging and risky undertaking. Trading those companies that have announced a “strategic-process” does not guarantee a favourable result. For example, a larger junior producer that announced such a process early last year resulted in no bidders for the company and as a result its share price has since sold off over 55%.

There has been some concern as of late regarding the sustainability of commodity prices and the impact on the resource heavy Canadian equity market. Investors appear rightly worried about the impact from the conclusion of Quantitative Easing (QE2) and the recent indicators showing a slowdown in global economic activity.

The S&P TSX has performed quite well gaining 4.7% since January 2007 compared to the S&P 500 that is off -7.2% over the same period (priced to June 1, 2011). Not surprisingly, commodity prices have played a key role in this outperformance as the iShares S&P/TSX Capped Energy Index Fund (XEG) gained a modest 3.8% while the iShares S&P TSX Capped Materials Index Fund (XMA) has increased an eye opening 57.7% over the same period.

That said, the Energy index has clearly not participated with the run-up in oil prices that have increased approximately 56% since January 2007. This is seen in the oil focused companies that comprise the XEG such as Suncor Energy (SU), the largest weighting in the index, that has actually lost -14% over this period. Also according to a recent report by TD Newcrest, the XEG/WTI ratio is currently at 0.23 on a currency adjusted basis, which brings it below the five-year historical range.

What we find interesting is that some natural gas focused companies such as EnCana (ECA) have performed especially well considering natural gas prices have been abysmal. For example, EnCana is up 28.8% since January 2007 while AECO natural gas prices are down -37.2% over the same period.
So what is this all telling us?

In our view, on the whole oil focused companies are reflecting much lower oil prices in their valuations while gas focused companies are reflecting higher natural gas prices. We think this presents some interesting defensive strategies should investors wish to remain invested in the sector during this current period of excessive volatility.

In particular, during these periods we favour fundamentally strong companies that pay a distribution that is sustainable under lower commodity prices. For example, there are some oil focused (including natural gas liquids – NGLs) companies out there that are currently yielding a greater than 4% to 5% yearly distribution with the excess cash flow from high oil prices being allocated to generating growth in production and reserves. Should oil prices retreat, these companies should be able to scale back their growth objectives while maintaining an attractive payout – so the investor gets paid while the broader markets correct thereby offsetting some of the downside.

Secondly, we’ve noticed that natural-gas levered companies have performed reasonably well during the past few months outperforming the underlying commodity. This strength could continue heading into what is forecasted to be an above normal hurricane season, although perhaps the better trade could be in owning the commodity outright than the gas focused producer.

Lastly, we also look to the option market as a means of further risk-management in addition to taking advantage of the current volatility to generate attractive tax-efficient income on our core holdings. For example, we’ve noticed the volatility of Canadian oil and gas stocks has risen from a very comfortable annualized 16% at the beginning of the year to nearly 28% currently.

In conclusion, investors have been rewarded for going out with a strong offensive plan in recovering markets not unlike what has transpired over the past two years. Unfortunately volatility works both ways and therefore it also pays to have a strong defensive plan during periods of uncertainty.

One of our cardinal rules when evaluating potential investments is to look at the return potential on a risk-adjusted basis. This especially applies to the Canadian oil and gas market where smaller independent producers are susceptible to greater downside risk and sensitivity to commodity declines than their larger counterparts.

To help explain this we think it’s important to understand the growth versus risk relationship in the sector. Essentially, as a company grows in production size, it becomes more and more challenging to deliver a similar growth profile – less growth. However, the trade-off is that larger companies have stronger capital efficiencies and higher levels of cash flow to fund their projects. Therefore, their cost of capital falls in addition to being less dependent on the secondary markets for capital – less risk.

First, we’ll address the growth relationship using approximate industry averages in two examples: an intermediate sized exploration and production (E&P) company, a junior and emerging sized E&P company.

The intermediate E&P will typically have a lower average corporate decline rate on its more mature production base. A junior or emerging E&P will on average have a higher decline rate given a newer production profile and higher production per well concentration. That said, it doesn’t take much to deliver significantly higher growth rates for the junior or emerging E&P because it requires a lot less wells to have a material impact.

For example, a 1,000 BOE/d junior and emerging E&P seeking a 50% annual growth rate will on average have to find 850 BOE/d in the year in order to replace its declining volumes and add the remaining production to meet its objective. This can be done with anywhere from two to 10 wells depending on the project.

Compare this to an intermediate E&P with 30,000 BOE/d that will have to replace approximately 6,000 BOE/d per year just to offset declines. In order to deliver a target 15% annual growth rate it will have to add a total of 10,500 BOE/d in the year. This could prove challenging on a number of fronts including access to services, land positioning, weather, regulatory delays etc.

However, this doesn’t mean that the junior and emerging E&P is the better investment. The larger a company grows the more cash flow it will have to fund its exploration and development program. Larger companies also usually have greater access to capital full-cycle in addition to a lower cost of capital advantage. This results in a less risky and sometimes more efficient growth profile.

Source: TriVest Wealth Counsel Ltd. (CF netbacks using 2010 averages)

For example, we calculate the aforementioned 1,000 BOE/d junior and emerging E&P will have to spend in excess of three times its cash flow to meet its 50% growth objective. Therefore, it is strongly dependant on the secondary markets for capital which may or may not be there depending on the broader market. This compares to the larger 30,000 BOE/d that is able to self-fund its 15% growth objective by using its cash flow. Therefore there is much greater certainty in the larger producer meeting its objectives full-cycle.

We carefully manage this relationship by owning a basket of oil & gas stocks with a higher concentration among the senior and intermediate E&Ps. This allows us to use the active option market to further manage the risk in what at times can be a volatile sector.

Lastly, junior and emerging E&Ps should be in most oil and gas portfolios because of their attractive growth profile. However, we recommend a tactical approach to owning this group with weightings depending on the broader market such as general access to capital. In addition, proper risk-management in this group requires very active due diligence as operations can have a very material impact.

We continue to recommend Canadian energy to be a core part of any investment portfolio however, it can at times be overdone especially among those earning a living from the industry.

This concentration can also be compounded during periods of excessive returns being generated by the sector. For example, investors have bid up the junior and intermediate oil & gas sector an impressive 240% from its February 2009 lows to its March highs this year. A common response during these times is why would you want to own anything else?

The answer to this question becomes clearly evident during periods of excessive volatility not unlike what has recently occurred in the energy markets. Canadian oil and gas stocks peaked in March of this year and have since fallen over 15% from their highs. Oil prices weren’t too far behind falling over 15% from their end of April highs.

More importantly, the average volatility of Canadian oil and gas stocks has risen from a very comfortable 12.5% at the beginning of the year to near 25% currently.

We would expect this volatility to continue with more downside risk than upside potential given we are nearing the conclusion of the U.S. Fed’s second round of quantitative easing.

For those arguing for diversification via the broader S&P TSX, commodity related sub-sectors which include materials and energy currently represent nearly 40% of the index. The remaining 60% also has some form of indirect exposure to commodities. This heavy commodities exposure can be seen in the performance of the Canadian equity markets in comparison to the U.S. equity markets.

In total, the S&P TSX is approximately flat on the year as it has sold off over -6% from its early April highs. This compares with the DJIA index which is down only 1.5% from its early May highs and is up over 9.0% on the year.

The last few weeks have therefore demonstrated the importance of active risk-management strategies in an equity portfolio. These strategies are especially important with the highly weighted and highly volatile energy sector. While these strategies often require a lot of time and expertise to implement, they ultimately assist in the preservation of capital when a sector turns.

That is not to say all investors can’t manage their energy investments prudently themselves. We know a lot of industry professionals who due to their senior positioning in the sector can take a hands-on approach to managing their investments and risk as an officer and/or director of the companies they are invested in.

However, for those who don’t have the expertise to stay on top of the highly active and volatile sector we would recommend the use of an experienced hedge fund manager. When searching out such a manager our check list would include such items as:

1) What specifically are their risk-management strategies? This especially applies to those funds claiming an “absolute-return” focus. We encourage asking specifically what strategies are in place to protect from sudden increases in volatility not unlike what has happened recently in the sector.

In our view, “buy-and-hold”, and “stop-losses” are red flags and shouldn’t be classified as effective risk-management strategies. Hedging in our view also doesn’t mean “levered-long” or leveraging speculative positions with investors capital.

2) What kind of hands-on experience do they have in the sector and how diligent are they in managing their holdings? This means staying on top of their energy holdings including knowing such particulars as the quality of the management teams, financial strength, capital efficiencies, details of the operations, drilling programs, well concentration etc.

It is also important to be aware of the larger broader trends such as commodity exposure, funds flow into and out of the sector and/or company, and overall access to capital.

3) What is the size of the fund and is it appropriately matched to the manager’s investment philosophy? For example, a $200 million fund that invests primarily in small-capitalization junior oil and gas companies may have quite a difficult time effectively buying and selling positions given the lack of liquidity in the sector.

4) How many holdings (companies) are in the fund? Generally over 25 to 30 holdings can prove challenging for one fund manager to stay on top off. It is also not uncommon to see larger funds “closet-index” by holding a large numbers of holdings in roughly the same proportion as the TSX Oil and Gas sub-index.

In conclusion, we believe Canadian oil & gas should be a core component of any investment portfolio even in periods of excess volatility in the sector.

Risk-management allows investors to own the sector long-term while managing the near-term volatility. If done right, an investment in the Canadian oil & gas sector can offer superior long-term risk-adjusted returns.

There have been more than a few pundits lately questioning the speculative nature of the commodity market and the energy sector. That said, we find it quite interesting that while oil prices have rocketed 68% over the past five years, the S&P TSX Capped Energy Index has actually lost 5.5% over the same period.

For example, oil-weighted producers Suncor and Canadian Oil Sands are down approximately 13.1% and 10.1% respectively over the past five years.

This also compares to the broader S&P/TSX composite index that is up about 12.1% over the same period. In addition, TSX is only within 7.8% of its all-time highs versus the Capped Energy Index that is still off approximately 27% from its highs.

So in our view, there appears to be some value left in the Canadian energy sector. However, there are many sub-sectors for investors to choose from including the integrated, senior, intermediate and junior producers.

Given the greater trading liquidity among the mid and larger capitalization companies, we zeroed in this week on the senior and intermediate producers. Specifically, we used the iShares S&P TSX Capped Energy Index (XEG/TSX) as a proxy for the senior producers and the Horizons GMP Junior Oil and Gas Index ETF (HJE/TSX) as a proxy for the intermediate producers.

In particular, over 70% of the XEG is comprised of companies with an average market cap of approximately $30 billion. This compares to the HJE, where nearly 75% of it is comprised of companies with an average market cap of around $1.8 billion.

According to our calculations, the senior producers have actually slightly underperformed the intermediate producers on both an absolute return basis and risk-adjusted return basis in the longer-term.

For example, we calculate that in the past five years the HJE has delivered a -1.2% total return with a -0.06 sharpe ratio (a measure of risk-adjusted performance). This compares to the XEG that lost -5.5% with a -0.18 Sharpe ratio over the same period.

In the past three years, the results are more pronounced with the HJE losing only -1.7% with a -0.06 Sharpe ratio, while the XEG lost -14.2% with a -0.32 Sharpe ratio.

Source: Bloomberg data, HJE historical back-tested data

What surprised us is that a composite of primarily mid-cap producers delivered more return per unit of risk when compared to a composite of larger-cap producers.

Does this mean there is better value going forward in owning the intermediate producers?

Not necessarily, as we believe it depends on the near-term outlook. From a performance standpoint, the HJE has recovered approximately 215% from its lows to within 21% of its June 2008 highs. This compares to the XEG that gained approximately 93% from its lows but is still off 27% from its highs.

More importantly, we think the next prudent step should be to compare estimated cash-flow multiples under the forward curve to see which sub-sector offers the most value going forward. The results might also surprise you.

The 4th Asian Ministerial Energy Roundtable was held in Kuwait this past week and in particular, a presentation by the Institute of Energy Economics, Japan (IEE) caught our attention. The presentation entitled the “Study of Asian Energy Demand and Supply Outlook” highlights Asia’s growing importance on the global energy stage. It can be read here.

Specifically, in its study the IEE is forecasting that Asia’s energy use will grow much more rapidly than other regions representing approximately 72% of the incremental growth of global energy demand towards 2035. In addition, Asia’s share of world primary energy demand is estimated to grow to over 50% by 2035 from 38% in 2008. With regard to crude oil, the IEE is forecasting that Asia’s share of global oil demand will grow to nearly half of the total by 2035 up from roughly a third in 2008.

Coal and oil represented 78% of Asia’s total energy demand in 2008 and is expected to remain strong although it is estimated to fall slightly to 69% of the total by 2035. The IEE is also predicting that the share of natural gas as a percent of total energy use in Asia will increase substantially from 16% in 2008 to 21% by 2035. This growth is anticipated to come primarily from an increase in use in power generation.

China plays a major role as it currently represents approximately 44% of Asia’s total primary energy demand. This is forecasted to remain strong with the IEE estimating a slight decrease to 42% of the total by 2035. Therefore China’s influence on the energy commodity complex, especially crude oil prices is expected to continue to expand alongside total growth in Asian energy demand.

What is especially interesting is the existing relationship between China’s Shanghai Index and commodity prices. According to our calculations, China’s Shanghai index leads the Thomson Reuters/Jefferies CRB Commodity Index, a basket of 19 commodities, by four months with a 77% correlation. We also calculate a 74% correlation with the oil price on the same four month lag.

If this relationship holds going forward it doesn’t bode well for crude oil prices in the near-term as the Shanghai Index is up only 7% this year while oil prices are up nearly 23%. This is not surprising given what many are calling a “speculative premium” in oil prices due to ongoing civil unrest in the Middle East and North Africa.

Commodities have garnished a lot of attention given they have been a top performing asset class over the past two years. For example, the Thomson Reuters/Jefferies CRB Commodity Index, a basket of 19 commodities, has rebounded over 79% from its February 2009 lows.

In particular, crude oil prices have been a major contributor to this performance gaining an impressive 141% over the same period. However, there has been a noticeable pick-up in the volatility of commodity prices over the past few weeks, especially crude oil.

Pundits have been adding fuel to the fire by placing the blame on speculators for driving commodities to new highs. As a result many are touting a so-called “speculative-premium” to prices which should be lower based on current fundamentals.

So, we decided to roll up our sleeves to see if there is any merit to these views. To begin, we went to the U.S. Fed as some have cited its Quantitative Easing (QE) programs as a primary factor driving commodity prices higher. The theory is that the U.S. Fed is flooding the market with cheap money resulting in a reduced U.S. dollar (USD), and inflated commodity prices.

Specifically, the Fed purchases Treasuries in the open market thereby resulting in a low-yielding USD. This then encourages speculators to use the currency as a very inexpensive way “to finance riskier higher-yielding assets, such as equities, commodities and emerging market and commodity-linked currencies” as defined in the Financial Times.

This action of selling the USD against a long position in higher-yielding riskier assets is also termed the USD carry trade.

There may be some merit to this argument as based on our calculations and Bloomberg data, there is an astounding 95% correlation with the Fed’s total Treasury purchases and the CRB Commodity Index since the first round of purchases began in April/May 1999.

We also calculate an 88% correlation between the Fed’s purchases and crude oil prices over the same period.

Bloomberg data; original chart by Russ Winter, Minyanville

Interestingly, it’s not only commodity prices that have been driven higher by the U.S. Fed’s open market operations. We’ve calculated a near 89% correlation with their purchases and the performance of the S&P500 index.

The Fed has also been successful with lowering the value of the USD. Since the announcement of a second round of Quantitative Easing (QE2) in the summer of 2010, the USD Index has fallen over -15% from its highs.

Over this same period we calculate a negative -82.5% correlation between the USD Index and the CRB Commodity Index, and a -73% correlation between the USD Index and crude oil prices.

This brings to mind an old analogy we heard a number of years ago: You buy a horse for three goats, go on vacation and upon your return the horse is worth ten goats. Now, is it a bull market in horses or a bear market in goats?

The bottom line in our view is that perhaps the symptoms are being blamed rather than the actual cause. What we mean by this is that speculators will always be speculators as they are only taking advantage of the massive injection of liquidity into the market by the Fed. This has consequently resulted in some unintended consequences – inflated asset prices.

The $600 billion question is have global economies recovered enough over the past two years to sustain current commodity prices upon the conclusion of QE2 this June and in absence of another round of quantitative easing?

Over the past two months there has been a noticeable increase in natural gas focused joint venture and acquisition activity.

What caught our attention this past week was Talisman Energy’s announcement that it has done another deal with Sasol Limited whereby it sold a 50% working interest in a portion of its Montney shale play in N.E. British Columbia (Cypress A) for total consideration of C$1.05 billion. This follows a similar 50% deal with Sasol in the same region and play-type (Farrell Creek) announced back in December.

Sasol is known for its Gas-to-Liquids (GTL) technology and currently has GTL projects operating in South Africa and Qatar, and a project under construction in Nigeria. Sasol and Talisman plan to undertake a feasibility study to build a world scale GTL facility in Western Canada, which will encompass using the joint venture lands as a secure feedstock of natural gas for a 48,000 barrel per day facility with the option to expand to 96,000 barrels per day.

We’ve read that the feasibility study would take one to two years, with another three to four years for sanctioning and construction should the joint venture proceed.

GTL isn’t a new technology as it was invented in 1923 by two German scientists, Franz Fischer and Hans Tropsch, when they discovered the catalytic conversion of monoxide and hydrogen into synthetic hydrocarbons.

The GTL process involves feeding natural gas into a generator where it is converted into synthesis gas (similar to methanol and ammonia) and then converted into GTL fuels via the Fischer-Tropsch reactor. GTL fuels can then be used in existing diesel engines and infrastructure.

On average the process requires approximately 10 mcf of natural gas to create a barrel of GTL fuel, although this can vary somewhat with the overall scale of the GTL plant.

High capital costs associated with building GTL facilities has been a major stumbling block in the past hindering the overall pace of development. However, this technology currently makes a lot of sense in the current commodity environment with oil prices trading at a significant premium to natural gas.

For example, Shell recently completed its 140,000 barrel per day Pearl GTL facility in Qatar at a total cost of $19 billion. According to Forbes Communications, the project would generate $4.5 billion a year at $50/bbl oil prices resulting in a four-year payout. The project would thereby have an impressive payout of less than two years with oil prices currently in excess of $100/bbl.

“The attractiveness of these projects (GTL) is increasing in the high oil price environment and as long as the technology can be made to work,” added Forbes in the March 2008 Upstream Online article.

In our view, this technology is a “natural” fit in regions where there are large sources of stranded unconventional natural gas reserves such as North America. This could also provide a strategic alternative to building new pipelines and LNG export facilities in these regions.

There is no doubt that there is significant potential for GTLs as a clean and secure source of fuel, albeit it remains in the early stages of commercial development. It is very encouraging to see it being tested in Canada as it would make an excellent complement to the country’s oil sands and further promote Canada’s strategic importance on the global energy stage.

It would also contribute to Canada’s economy as for example Shell’s Pearl project in Qatar required a total of 200 million man hours to build and at its peak had more than 40,000 workers on the ground.

Lastly, on a more selfish note, perhaps having an alternative lower-cost feedstock to crude oil would result in lower prices at the pumps? One can only hope, or at least run a feasibility study.

Martin Pelletier, CFA is a Portfolio Manager at TriVest Wealth Counsel Ltd, a Calgary-based private client and institutional investment management firm specialising in discretionary risk-managed balanced portfolios as well as specialty offerings including an oil & gas hedge fund. For more visit TriVest Wealth’s Web site www.trivestwealth.com or Twitter twitter.com/TriVestWealth